Thesis Overview
In this new era of low hydrocarbon prices, North American E&Ps can no longer pursue reserve and production growth at any cost. We believe that equity investors have, and will continue to, shift their primary preference away from growth, and to profitability: full-cycle economics, returns on invested capital, and free cash flow.
We are adding Short Chesapeake Energy Corp. (CHK) to our Best Ideas list with a fair value range of $3 - $7/share based on an Investor Recycle Ratio of 1.5x at above-current-strip commodity prices. It is possible that CHK could become severely distressed over a 2 – 4 year time frame, calling into question any equity value at all, should commodity prices remain low for long. At the current price of $13.50/share, we believe that CHK is pricing in ~$90 WTI and ~$4.00 Henry Hub. CHK equity investors are paying $1.90 per proved Mcfe for a company that only generates $1.60 of undiscounted EBITDA per Mcfe produced (at $65 WTI and $3.25 Henry Hub).
In our view, the market is mispricing CHK’s move to one of the highest-cost, large-cap E&Ps in North America, largely due to its massive and growing midstream expenses, a situation that worsens in the years ahead. These iron-clad, multi-decade commitments make CHK a highly-unlikely takeout candidate, and may also make asset sales difficult. We also believe that the market is underappreciating CHK’s leverage due to its $2.9B cash balance and $1B realized hedge gain in 2015; by our model CHK will burn ~$1.5B of cash each year for the foreseeable future, and net debt / EBITDA will be ~5.0x at YE16.
CHK is no longer growing production and its economic earnings / free cash flow are sharply negative; in 2016 we expect CHK to lose ~$1.2B ($1.85/share) at current strip prices, before minimum volume commitment payments. We estimate that CHK needs ~$70 WTI and ~$4.00 Henry Hub just to sustain production and be cash flow neutral. In short, unless commodity prices increase meaningfully from current levels, the long-term outlook for CHK is dire.
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We will publish our analysis supporting our short CHK thesis in a comprehensive slide deck on Thursday, June 11th. We will host a conference call that day at 1pm EST to walk through the key slides and field questions. The slide deck and dial-in information will be sent to all current subscribers next Thursday morning. The slides and call will explore:
- CHK’s full-cycle cost structure with an emphasis on its midstream expenses and price differentials;
- A deep-dive into the CHK / ACMP gas gathering agreements (it’s not the minimum volume commitments that really hurt!);
- Comparative analysis of CHK’s full-cycle economics relative to peers (E&P investing is often a relative game);
- Valuation analysis and commodity price sensitivities.
- Catalysts, risks, sentiment
- Sidebar: Should Williams Companies (WMB) be worried?
Kevin Kaiser
Managing Director
